Nov 29, 2010
The Hangover, Part II. WSJ Editorial
New derivatives rules could punish firms that pose no systemic risk.
WSJ, Nov 29, 2010
Not even Mel Gibson would want a role in this political sequel. Readers will recall the true story of Congressman Barney Frank and Senator Chris Dodd, two pals who stayed up all night rewriting derivatives legislation.
The plot centered around the comedy premise that two Beltway buddies would quickly restructure multi-trillion-dollar markets to present their friend, President Barack Obama, with an apparent achievement before a G-8 meeting. As in the movies, the slapstick duo finished rewriting their bill just in time for the big meeting in Toronto last June.
But after the pair completed their mad-cap all-nighter, no hilarity ensued. That's because Main Street companies that had nothing to do with the financial crisis woke up to find billions of dollars in potential new costs. The threat was new authority for regulators to require higher margins on various financial contracts, even for small companies that nobody considers a systemic risk. The new rules could apply to companies that aren't speculating but are simply trying to protect against business risks, such as a sudden price hike in a critical raw material.
Businesses with good credit that have never had trouble off-loading such risks might have to put up additional cash at the whim of Washington bureaucrats, or simply hold on to the risks, making their businesses less competitive. Companies that make machine tools, for example, want to focus on making machine tools, not on the fluctuations of interest rates or the value of a foreign customer's local currency. So companies pay someone else to manage these risks. But Washington threatens to make that process much more costly.
Messrs. Frank and Dodd responded to the uproar first by suggesting that the problem could be fixed later in a "corrections" bill and then by denying the problem existed. Both proclaimed that their bill did not saddle commercial companies with new margin rules. But as we noted last summer, comments from the bill's authors cannot trump the language of the law.
Flash forward to today, and the Commodity Futures Trading Commission (CFTC) is drafting its new rules for swaps, the common derivatives contracts in which two parties exchange risks, such as trading fixed for floating interest rates. We're told that CFTC Chairman Gary Gensler has said privately that his agency now has the power to hit Main Street with new margin requirements, not just Wall Street.
Main Street companies that use these contracts are known as end-users. When we asked the CFTC if Mr. Gensler believes regulators can require swap dealers to demand margin from all end-users, a spokesman said, "It would be premature to say that a rule would include such a requirement or that the Chairman supports such a requirement."
It may only be premature until next month, when the CFTC is expected to issue its draft rules. While the commission doesn't have jurisdiction over the entire swaps market, other financial regulators are expected to follow its lead. Mr. Gensler, a Clinton Administration and Goldman Sachs alum, may not understand the impact of his actions outside of Washington and Wall Street.
In a sequel to the Dodd-Frank all-nighter, the law requires regulators to remake financial markets in a rush. CFTC Commissioner Michael Dunn said recently that to comply with Dodd-Frank, the commission may need to write 100 new regulations by next July.
"In my opinion it takes about three years to really promulgate a rule," he said, according to Bloomberg News. Congress instructed us to "forget what's physically possible," he added. The commission can't really use this impossible schedule as an excuse because Mr. Gensler had as much impact as anyone in crafting the derivatives provisions in Dodd-Frank. No surprise, the bill vastly expands his agency's regulatory turf.
And if anyone can pull off a complete overhaul of multi-trillion-dollar markets in a mere eight months, it must be the CFTC.
Just kidding. An internal CFTC report says that communication problems between the CFTC's enforcement and market oversight divisions "impede the overall effectiveness of the commission's efforts to not only detect and prevent, but in certain circumstances, to take enforcement action against market manipulation." The report adds that the commission's two primary surveillance programs use incompatible software. Speaking generally and not in response to the report, Mr. Gensler says that the agency is "trying to move more toward the use of 21st century computers," though he warns that "it's a multiyear process." No doubt.
The CFTC report also noted that "the staff has no standard protocol for documenting their work." If we were tasked with restructuring a complex trading market to conform to the vision of Chris Dodd and Barney Frank, we wouldn't want our fingerprints on it either.
The report was completed in 2009 but only became public this month thanks to a Freedom of Information Act request from our colleagues at Dow Jones Newswires. Would Messrs. Dodd and Frank have responded differently to Mr. Gensler's power grab if they had realized how much trouble the CFTC was having fulfilling its traditional mission? We doubt it, but it certainly would have made their reform a tougher sell, even to the Washington press corps.
Congress should scrutinize this process that is all but guaranteed to result in ill-considered, poorly crafted regulation. In January, legislators should start acting, not like buddies pulling all-nighters, but like adults who understand it's their job to make the tough calls, rather than kicking them over to the bureaucracy with an arbitrary deadline.